Saturday, December 31, 2011

For sometime now, high inflation has been the central concern about the Indian economy. Inflation rate, driven by run-away food prices, have remained at a very high plateau throughout the year. Core inflation too has been hovering at the 7-8% range, indicating that inflationary expectations have become embedded into the economy.

In response, the RBI has been tightening monetary policy. Since March 2010, it raised interest rates in baby steps 13 consecutive times.

The bank credit growth has declined continuously reflecting the tight credit market conditions. Commercial credit off take has been an inevitable casualty.

It is now strongly believed that the sustained increase in interest rates has started to badly hurt economic growth. The monthly industrial production figure has been on continuous decline since April. The most shocking news was the revealation that industrial production contracted in Novemeber.

The quarterly GDP growth rate has been falling continuously for the past seven quarters and the slowdown gathered momentum this year. Suddenly, the near double digit growth rates, which was being taken for granted, appears distant.

It is therefore no surprise that business confidence has plumetted. The the NCAER-MasterCard Worldwide Index of Business Confidence, which measures the level of optimism that people who run companies have about the performance of the economy and how they feel about their organizations’ prospects, has declined to 125.4 in October of 2011 from 145.2 in July of 2011.

Excellent graphics from the Wonkblog, BBC, and the Atlantic. All graphics below highlight important economic and social trends in a most striking manner.

It is no secret that any meaningful attempt to rein in America's debts has to involve addressing the burgeoning public health care expenditure. The graphic below makes this clear. Relentlessly rising health care costs coupled with demographic changes are driving the growth of these programs, while the open-ended structure of these programs is responsible for much of the increase in health care costs.

This graphic captures the extent of political polarization in the US. In the late 1960s, the most conservative Democrats in the House and the most liberal Republicans voted together frequently enough (as shown by the overlap between the two distributions) to make centrist legislating successful. By the late 1980s, that overlap was dwindling and today, it is largely gone.

Inequality is already one of the most important concerns for the US economy. As the graphic shows, corporate profits have not only recovered their post-recession highs, they’ve surpassed it and are growing, even as workers compensation as a share of the economy is declining continuously.

Thomas Gallagher of Scowcroft Group points out from the graphic below that the steep bull market since the early 1980s and the fact that previous such bull markets were preceded by pretty severe bear markets, is reason enough to be minimize expectations for overall stock market gains over the next several years.

Given the extent of job losses during the Great Recession, this Hamilton Project graphic shows that it may be years before the US economy regains the pre-recession level of jobs. If the economy adds about 208,000 jobs per month, which was the average monthly rate for the best year of job creation in the 2000s, then it will take until February 2024 — over 12 years — to close the jobs gap.

The chart below shows the real GDP in the US and the level of total civilian employment from 2002-2011. Its trends are an indicator of the gravity of labour market problem facing the US economy. While the total output has regained the pre-crisis level, the labour market is stuck way below. In other words, the US economy is producing the same output as in Q4 2007 with 6.6 million fewer workers. This jobless recovery points to a combination of increased productivity and labour market shifts (towards jobs which employ fewer jobs).

The graphic below captures the true magnitude of the global macroeconomic imbalance. It highlights the explosion of current account surpluses and official investments of delveloping economies in foreign financial assets, especially US Treasury Bonds. The mirro image of this is the rise in current account deficits in the developed economies.

Tyler Cowen's book, The Great Stagnation, has drawn attention to the stagnation in the Total Factor Productivity (TFP) of the US economy since the early 1970s. TFP is a measure of how much the economy is receiving a boost from innovation and new ideas, as opposed to, say, people working longer hours or taking a second job.

The graphic below highlights the power of the Fed's monetary policy announcements. On August 9, 2011, the FOMC meeting minutes announced that the economic conditions were 'likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013'. The market reaction was impressive.

One of the most powerful measures of the depth of the Great Recession is the output gaps that have emerged in both sides of the Atlantic. Bridging them could take years.

The two illuminating graphics ought to clarify the source of America's current debt crisis. It clearly points to the Bush legacy - tax cuts and Iraq-Afghan wars - as the main drivers of the ballooning deficit. Further, the much maligned stimulus spending and bailout policies have contributed only marginally to the debt stock and deficit. However, the loss of revenues due to the economic downturn has had a very significant effect.

The distinguishing characteristic of the dismal landscape is the policy gridlock that has gripped a deeply divided American political establishment. Europe too suffers the same malaise.

But this has not prevented the US Government and the Federal Reserve from rescuing financial institutions with an extraordinary tax payer sponsored bailout. However, the equally beleaguered tax-payers themselves have not benefited similarly. The unemployment rates remain high and and large numbers of mortgage holders continue to have negative equity on their houses. It is therefore no surprise that aggregate demand remains weak and economy anemic.

The graphic below represents the stark choice facing policymakers in the US. Shockingly, the second group's request comes on the back of the massive financial sector bailouts.

Fixing the financial market regulation system is proving a difficult, with little unanimity on the details. The graphic below is illustrative of this and much of macroeconomic policy making itself. The policy responses to the sub-prime bubble and its consequent Great Recession resembles the parable of the blindmen and the elephant.

Even as US was experimenting with monetary accommodation, the Europeans pumped for fiscal austerity.

Friday, December 30, 2011

I am a strong believer in the use of graphic visualizations as decision support and to increase workplace productivity. Fast Company has a link to its selected 22 infographics of the year. The one that really stands out for me is the TimeMap created by Vincent Meertens.

TimeMap is a visualization aimed at commuters that maps locations based on the time taken to travel to them from a particular location. It is dynamic and the shape of the map varies in response to changes in traffic and travel options. The currently available web version of TimeMap plots train travel times across Netherlands.

Load TimeMaps from anywhere in the country, and it automatically checks your location, shows the nearest train station, and charts trip times around the country in rings, with each colored ring representing another 30 minutes. Most importantly, the map is live. It grows and shrinks throughout the day, as travel times themselves grow and shrink; the bigger the map, the longer it’ll take you to get around... the map expands at night, when trains run infrequently or not at all, then contracts during the day, when trains run on their regular, zippy schedule. Track delays? The map grows again.

TimeMaps can be useful to generate maps for air and road travel times. One option would be to integrate mobile phone traffic data into the TimeMap application and generate real-time maps of traffic conditions and travel options in any city. Characteristics of the mobile phone data can be used to identify those used by road users and its mobility patterns can give information about road traffic conditions.

Such cognitively salient data visualization can provide excellent decision support for road users and help everyone optimize their travel times and thereby minimize traffic problems. The real-time nature of the information and its availability in the simplest form to its consumers will help them use it optimally and thereby generate the most efficient traffic outcomes.

Such visualization tools become potent traffic force multipliers in cities where commuters have multiple travel options. For example, the presence of good public transit system helps commuters effectively switch across different travel modes and travel routes to make their daily peak-hour travel decisions in a manner that would contribute towards optimizing traffic patterns.

John Kay describes the European response to the sovereign debt crisis as a Martingale betting strategy - increase your stake everytime you lose, in the expectation that a win on the next game would recoup all your losses and leave you ahead. I feel that this description is also appropriate for much of what passes as unconventional monetary accommodation being pursued by central banks on both sides of the Atlantic.

Lower rates, print money, inject liquidity, buy assets, do maturity transformation, and so on, all in the expectation that the "animal spirits" will be revived and market valuations will return to its bubble-era days (given the magnitude of losses suffered, only such recovery can restore them). This would make the Greenspan put look a small-time bet. The recovery martingale bet through extraordinary monetary accommodation is arguably the mother of all bets.

John Kay writes,

"Whenever European institutions have failed to end the current crisis, they have returned with a new, larger, commitment. “We will do what it takes”, “we will see it through”, is the strategy, if it can be called that. “Just in time, just enough”, is how my colleague Martin Wolf last week described the tactics. These are the key components of the martingale system. But debt markets illustrate a malevolent game. A player on the other side of the table – global financial markets – has very large resources, and can ensure that each round of the game can be played for very large stakes.

The wise person’s reaction to the casino is not to go there. The next best course is to plan an early night. Leave while you are ahead, and if you cannot do so, accept a small loss. If the eurozone had quickly recognised defeat in Greece, it would have suffered a manageable failure and learnt an important lesson for the future. Instead it has followed the martingale. As the size of the bet grows after a run of losses, the commitment to do what it takes becomes steadily less credible.

The gambler who is confident his system will work looks to rich friends. When the indulgence of Berlin was exhausted, a banker was dispatched to Beijing. Now the players look to the only remaining credible supporter. Surely the European Central Bank can enable them to see the night through. The ECB really does have infinite resources: if it runs out of money, it can print more."

The fundamental urge behind the martingale strategy is the desire to restore the economy back to its pre-crisis normalcy. It is widely believed that this process of restoration can be achieved only through extraordinary monetary accommodation.

This strategy overlooks the possibility that a restoration of the pre-crisis normalcy may not only be not desirable but also unsustainable. It overlooks the severe excesses and inefficiencies that had got built-up in the boom years and the need to wring them out. It also glosses over the fortunate confluence of favorable factors that contributed to the long period of sustained low inflation, low unemployment and high economic growth rates. Now many of these factors have subsided or disappeared and the sins of the excesses have to be reaped.

The Martingale strategy is a classic case of kicking the can down the road and ignoring a continuous build-up of systemic risk. The perils of such a strategy are only too well known to be ignored.

Wednesday, December 28, 2011

Lane Kenworthy has an interesting post where he questions conventional wisdom on the winner-takes-all economy, where a few people at the top of each industry have seen massive increases in their incomes, whereas the take-home paychecks of the rest have remained stagnant.

Supporters of this trend argue that the differential is a well-deserved premium since it is a reward for hardwork and inventiveness. This line of analysis attributes a disproportionately high weight to the good performance of the company (it is another matter that even those with below average performance claim this premium!) to the quality of leadership. Supporters of the skewed financial market compensation in general, and executive compensation, in particular, have argued that the high financial rewards are a reflection of their performance and the innovation that goes along with it.

Since Apple and Steve Jobs are the modern benchmarks for innovation, Prof Kenworthy writes in the context of the discussion on what drove the late Jobs,

"Would Jobs and his teams of engineers, designers, and others at Apple have worked as hard as they did to create these new products and bring them to market in the absence of massive winner-take-all financial incentives... Jobs himself seems to have been driven mainly by a passion for the products, for winning the competitive battle, and perhaps for status among peers. The satisfaction of achieving excellence and of beating one’s opponents appears to have been far more important than monetary compensation. Excellence and victory were their own reward, rather than a means to the end of financial riches... The rise of winner-take-all compensation occurred simultaneously with surges in innovation and productivity in certain fields, but that doesn’t mean it was the cause of those surges."

I agree with Prof Kenworthy and am inclined to the argument that innovation at the highest levels is driven more by passion and desire for peer recognition than by financial rewards. Here are three more observations.

1. The fixation on financial rewards may be an example of availability bias at work. In the mainstream discourse, financial rewards have a deeply entrenched association with achievements and innovations. So there is a natural tendency to subliminally associate any innovation with financial rewards.

2. Further, there is also the strong correlation-causation bias in the winner-take-all interpretation. A successful innovation would naturally result in a flow of financial rewards. So, given the entrenched availability biases about financial rewards causing innovation, the immediate impulse is to attribute the innovation itself to the financial reward.

3. A wage premium is necessary to build up high quality teams that can collaborate in the development of innovative products. However, while intuitively true, this may require more deeper analysis. It would be instructive to examine the great modern day innovations, and assess the relative roles of large team-work and individual genius, in the genesis of the innovation. I suspect that the latter would bear a disproportionate share of the credit for such innnovations. It may be too much of a stretch to argue that Larry Page or Mark Zuckerburg or Niklas Zennström were motivated predominantly by the attractions of a winner-takes-all system and not their inherent personal motivation.

Alex Tabarrok weighs in with the argument that if it is to improve the standard of living of its people, India needs workers to move from less productive sectors like farming, retail, and so on to other more productive and higher value added industries, and retail trade liberalization hastens this process. I agree with the first point. The second, about retail trade liberalization hastening the process, though may be more contentious and needs a more nuanced appreciation.

It is surprising that Alex does not explore the argument further since he does acknowledge the perils of liberalization - the painful labour market transition and the fact that, atleast immediately, the losers generally outnumber the winners. He simply confines his analysis to a standard line - transitions always involve some pain; creation always involves some destruction; growth always involves change; the alternative, however, is stagnation.

I think this is pretty lazy, even specious, scholarship. Unfortunately, it is also widely prevalent in academic discussions on reforms. There is a reluctance or inability to think through the real world problems that come in the way of pushing through such reforms, especially in democracies. It is all the more surprising since these supporters do identify the potential challenge. But they refuse to think beyond stage one.

The case for any liberalization measure proceeds something like this. First trumpet the benefits of liberalization. Then gain enough support to liberalize regulations. The benefits start to flow, but accompanied by the pains of transition. Then rationalize that any liberalization will have losers, who may even be large in numbers, but "today’s losses and gains are fleeting, the permanent winners are the workers and consumers of the future who will know only the benefits of productivity".

India's tryst with retail liberalization has resonance with similar structural transformations across other sectors, both in India and elsewhere. The fundamental issues bear striking similarity with the conditions when China liberalized its markets and encouraged foreign investments. The newer firms ended up competing with large and uncompetitive public sector units (PSUs) thereby generating the risk of lay-offs by these PSUs. The US economy too, as Joe Stiglitz pointed out in his New Year essay in Vanity Fair, faces a similar labour market challenge as it transitions from manufacturing to productive services.

In all these cases, the key to successful transformation is the effectiveness in managing the losers or those displaced during the process. Traditionally, academicians and policy makers pay disproportionate attention to the reforms themselves while ignoring the more important issue of getting the mechanics of the transition process right. What needs to be done to rehabilitate those affected by the changes? What are the immediate and medium-term measures?

As democracies become increasingly politically divisive, effective rehabilitation strategies will become even more important if governments are to push through such reforms. China appears to have managed the transition effectively, albeit less efficiently. It kept the large and failing PSUs running with heavy state support. The spectacular economic growth in other sectors helped the government with the resources required to backstop this transition hemorrhage without curtailing the progress of the reforms. Now that the transformation has stabilized, the government is slowly removing its support for the PSUs.

Since the pains associated with the transition invariably comes in the way of the effective implementation of the reforms, it is critical that the mitigation cum rehabilitation plan gets the required focus. However, assuming that governments rarely get the transition plan right, a second best option would be, as the Chinese have done, to let the existing public systems continue to maintain life-support till the transition takes strong roots. While this has its costs, it will mitigate the hardships and ease the reform path.

In India's case, it is important that those likely to be displaced from retail trade be absorbed elsewhere in the labour market. This will not happen by itself and merely through the dynamics of economic growth and resultant job creation. It will require enabling policy frameworks and massive investments in education, especially in the acquisition of vocational skills. It will also require policies that encourage the creation of large enough self-employment opportunities.

Most importantly, it will need a universal social safety system that can atleast partially cushion those losing out from the bitter pain and social dislocation that follow. In any case, this social safety net is an essential pre-requisite for cushioning those most vulnerable from the vagaries of liberalization and increasing integration with the global economy. Unfortunately, the opportunity to establish a comprehensive socialsafety net is being side-tracked by the obsession with populist, inefficient and even wasteful piece-meal interventions.

The Economist has an interesting debate on whether persistent trade deficits are a bad thing. Hal Varian makes an important point about the fallacy of paying too much importance to headline trade deficit figures.

According to research by Ken Kraemer at UC Irvine, the component parts of the iPad are imported to China from South Korea, Japan, Taiwan, the European Union, the US and other places for final assembly. None of the component parts are made in China: it's only role is assembly. The value added by the final assembly in China is about $10. Nevertheless, each iPad exported from China to the US increases the US trade deficit with China by $275.

The same misleading accounting holds for other products. If China buys steel, aluminum, and machine tools from Australia and uses these parts to build a ship which they then export to the US, the total value of the ship is counted as an export for China.

On the same subject of statistical illusions, Paul Krugman posts that Ireland's reported recovery in competitiveness may not be a reflection of the true story.

Ireland is an economy that generates a lot of GDP — but not much GNP — out of capital-intensive, foreign-owned export sectors, such as pharma. And what has happened in the austerity era is that these sectors, which aren’t selling to the domestic market, have held up much better than labor-intensive sectors serving that domestic market. And this causes a spurious increase in labor productivity: if you lay off a construction worker but don’t lay off a pharma worker who basically watches over very expensive machines that produce a lot of output, it looks as if productivity has gone up, but in any individual sector nothing has happened.

In other words, the numerator (GDP) falls by a far smaller number than the denominator (workers) when a less productive domestic worker is displaced.

Update 1 (26/1/2012)

The Economist points to a study about iPad's production supply chain and writes about how trade statistics overstate trade figures

"According to a study by the Personal Computing Industry Centre, each iPad sold in America adds $275, the total production cost, to America’s trade deficit with China, yet the value of the actual work performed in China accounts for only $10. Using these numbers, The Economist estimates that iPads accounted for around $4 billion of America’s reported trade deficit with China in 2011; but if China’s exports were measured on a value-added basis, the deficit was only $150m."

China’s small contribution to total costs suggests that a yuan appreciation would have little impact on its exports. A 20% rise in the yuan would add less than 1% to the import price of an iPad. For imports such as clothing and toys the Chinese value added is much higher. But electrical machinery and equipment, with more complex cross-border supply chains, make up one-quarter of China’s exports to America.

Saturday, December 24, 2011

FT Alphaville points to an excellent speech by Canada’s central bank governor Mark Carney where he points to the inevitability of a prolonged period of deleveraging among the developed economies to shake off the mountains of accumulated debt. He feels that the global "Minsky moment" has arrived, and a combination of debt restructuring, inflation and growth need to be deployed.

The speech contains several superb graphics that beautifully captures the debt trap in which US and Europe have entrapped themselves. The balance sheets of households and governments on both sides of the Atlantic have worsened dramatically over the past decade or so.

Following the bursting of the sub-prime mortgage bubble, net household wealth of Americans dropped spectacularly. This wealth can be regained only through a combination of increased savings and recovery in asset values.

Europe experienced a hugely imbalanced and unsustainable economic growth after the monetary union. Cross-border lending exploded, capital was cheaply available, public spending grew, and booms ensued. This eroded competitiveness, especially among the peripheral economies with respect to Germany. Euro-wide price stability masked large differences in national inflation rates. Unit labour costs in peripheral countries shot up relative to the core economies, particularly Germany.

Financial globalisation, driven by savings glut in emerging Asia and consumption demand in the developed economies, led to the build up of external imbalances. The magnitude of these savings glut, best exepmlified by China's monstrous foreign exchange surpluses, allowed larger debt burdens to persist for longer than historically was the case.

All this was obviously not sustainable. When the bubble burst and Great Recession took hold, the consequences were severe. The World Bank estimates the world GDP output gap to be more than $7 trillion by 2017.

As these graphics reveal, all these economies built-up several critical structural imbalances over the past two decades. In all of them, compared to the previous two decades, public debts rose sharply, household wealth rose spectacularly, cross-border capital flows increased dramatically, and unit labour costs climbed. A fortunate confluence of favorable factors were inflating these bubbles and boosting economic growth.

Now that the bubbles have been deflated and the business cycle has changed direction, all these aforementioned macroeconomic indicators are naturally on the way down to their pre-bubble (not pre-crisis) norms. In many respects, this is a natural correction and there may be little that governments can do to avoid them.

As many Eurozone economies face their winter of discontent, there is an intense debate about the best possible route to recovery. Since, the underlying problem is one of eroded competitiveness, its recovery can be achieved either through internal (austerity and wage freezes) or external (currency depreciation) devaluation.

Friday, December 23, 2011

Widening inequality is arguably one of the most important socio-economic challenges facing societies, rich and poor, across the world. Unfortunately, despite the steep widening of inequality in recent years, it has not generated the anticipated level of social outrage.

In a recent article in the NYT, Ian Ayres and Aaron Edlinn, had called for a Brandeis tax, as a tax directly on inequality. The Brandeis Ratio is the average income of the richest one percent of household to the average median household income. This ratio has risen alarmingly from 12.5 in 1980 to 36 by 2006. The Brandeis tax be an automatic extra tax on the income of the top 1 percent of earners — a tax that would limit the after-tax incomes of this club to 36 times the median household income. It would therefore be an inequality capping tax.

In a series of posts in Freakonomics, they take their argument one step ahead and advocate that the debate on income inequality be framed in terms of "medians". They write,

"Framing income inequality in terms of "medians" is also part of a larger goal of making the median household incomes more salient... Part of our goal is to change the way politicians speak about income equality. Framing the income of the wealthy in relation to the median income will help us all keep in mind the relative success of the middle class.

It might even be useful to describe other things in terms of medians. A new Cadillac Escalade will run you 1.4 medians. A year’s tuition at Yale Law School is about .88 medians. We might even restructure government salaries so that they automatically adjust with the median... To raise the prominence of the median measure, government could standardize a "mi" symbol."

Behavioural psychologists have long pointed to the power of framing in re-orienting the human mind. In the instant case, absolute income numbers are not very effective in signalling about the degree of inequality. However, when the same is framed in terms of "mi", the extent of inequality becomes cognitively striking.

Similar framing can be an effective strategy in the various conservation (water, electricity etc) and environmental awareness campaigns. Water closets could be rated based on the number of buckets of water used. Air conditioners can be rated by describing their energy consumption as a multiple of that of a fan. In all these cases, the message is framed in a language that is readily graspable and therefore cognitively salient.

In this context, economist Robert Frank has constructed a Toil Index to more evocatively highlight the middle-class squeeze. It represents the number of monthly hours of work required to rent a house in an area served by a school of average quality. And it has just shot up vertically since the last decade.

Thursday, December 22, 2011

I blogged yesterday about the student learning levels crisis in India. In this context, as the search for solutions and policy approaches to improving learning levels are in progress, this graphic from Andrew Fraker (report not online) and colleagues of IDInsight provides valuable and credible enough clues.

The graphic, which presents the evidence from 34 rigorously evaluated studies from 9 countries (19 of them from India) on strategies to improve student learning outcomes, clearly points to the superiority of remedial education. In fact, he finds that interventions that combine remedial education and increasing accountability are the most effective strategy to improve learning outcomes. Interestingly, it also finds that interventions that focus on inputs and technology have very negligible or even negative effect.

Another less obvious point from the graphic is the wide dispersion in outcomes within the remedial education sample. It just shows that while, on the average, remedial education is very effective, its success lies in getting the design and implementation strategy right. Unfortunately, this is where we struggle to get the mix right and fail with the implementation. And this in turn brings undeserved discredit to remedial education itself.

Mostly Economics points to a fantastic graphic that maps the spectacular growth in "scholarly influence" of Prospect Theory, which examines decision making in conditions of uncertainty and risk, as measured by Journal citations and references in different fields. Daniel Kahneman and Amos Tversky published their landmark paper on Prospect Theory in 1979.

This visualization is also an example of the power of graphically illustrating concepts like growth in influence of ideas and trends.

Wednesday, December 21, 2011

It should not come as a surprise to anyone that student learning levels in our schools are abysmal. Numerous reports, most notably the annual ASER reports, have confirmed that our schools system is in a serious state of disrepair.

But two studies, highlighted in Mint over the past one week, point to a malaise that is much deeper, universal, and shocking in its magnitude. Our school education system is a national crisis, one that most seriously threatens our future economic growth prospects. The human resource plumbing of our economy needs immediate fixing.

Actual learning levels of students in our best schools are below global averages. Our students did well in areas that required memorization and procedural skills, but are way behind when it came to understanding, conceptual clarity, thinking and application...

India’s school education is in bad shape, not just the government- and low-fee private schools, but even the 'best schools' that are the exemplars for all other schools to emulate... These schools, where the students come primarily from upper middle-class homes, reflect significant gender and community bias and low social sensitivity.

The second study, PISA 2009+, evaluated 15-year-olds’ skills in overall reading, mathematical and scientific literacy on a comparative basis across 10 countries. Himachal Pradesh and Tamil Nadu, which are thought to be the best performing school systems in India, were part of the survey. Both came at the bottom, on par with Kyrgyzstan in all the three parameters.

Comparing with the full PISA 2009 study of 74 nations, Tamil Nadu ranked 72 and Himachal Pradesh 73, just ahead of Kyrgyzstan in mathematics and overall reading skills. Shanghai in China topped the PISA rankings in all three categories. Its findings brought out in Mint are shocking,

"In Tamil Nadu, only 17% of students were estimated to possess proficiency in reading that is at or above the baseline needed to be effective and productive in life. In Himachal Pradesh, this level is 11%. This compares to 81% of students performing at or above the baseline level in reading in the OECD countries, on an average... In other words, only a little over one in six students in Tamil Nadu and nearly one in 10 students in Himachal Pradesh are performing at the OECD average...

Only 12% of students in Himachal Pradesh and 15% in Tamil Nadu were proficient in mathematics against an OECD average of 75%; when it came to scientific literacy among students of class X, the proficiency level in Tamil Nadu was 16% and in Himachal, 11%, as against an OECD average proficiency of 82%. In Malaysia, 56% of students were proficient in reading and 41% in mathematics. Similarly, in the United Arab Emirates, the mathematics proficiency levels was estimated at 49% and for reading, 60%. Like India, both countries participated for the first time."

The key to improving learning levels in our schools is to improve the quality of classroom transaction. This demands replacing rote learning with instilling conceptual understanding in students. Teacher initiative and headmaster leadership are critical to achieving this transformation. However, the difficulty lies in achieving this transformation on the humunguous scale that India requires.

The real challenge is to do this in an environment where the odds are heavily stacked against such quality improvements - demotivated and disinterested teachers, headmasters without any initiative, students from adverse socio-economic backgrounds, deficient infrastructure, an eco-system which favors rote learning, and so on. Putting learning levels at the center of the agenda would be a good place to start the process of repairing our school education system.

Tuesday, December 20, 2011

In the second half of 2010, spurred by capital inflows, the rupee appreciated substantially against the dollar. Infosys CFO V Balakrishnan then called for urgent intervention by the RBI to stabilize the currency,

"The RBI should intervene right now to halt heavy speculative inflows through the FII (foreign institutional investments) route to reduce the currency volatility, which is currently ranging from 10-15 percent... With a trade deficit of $13 billion, such a wide currency fluctuation is unsustainable for the country as well as the software services sector, which depends largely on export revenues. We hope the central bank (RBI) will step in to ensure the quality of inflows."

Now, with the opposite trend playing out and rupee falling sharply, thereby boosting the rupee value of software exports, Narayana Murthy finds nothing amiss and finds it a general phenomenon,

"Value of rupee keeps fluctuating. This is normal. At some point of time value of Rupee was at 39 against a dollar."

The two contrasting, or opportunistic, remarks provide an insightful peek into India's software industry. The software sector, while undoubtedly globally competititive, benefits from substantial government support. It continues to enjoy most of the benefits extended to it as a sunrise industry in the nineties. The industry has lobbied intensely to retain the tax breaks given to exporters located inside the Software Technology Parks. The sector has the lowest effective tax rate of 15-18%, compared to the statutory corporate tax rate of 34%, and lobbies hard against removing tax exemptions.

Used to double digit growth rates for decades now, it is important that India's software sector adjust to the vagaries of global market place. Instead of relying on free lunches resulting from cheap labour, low tax rate or weak currency, the industry should seek to raise its competitiveness by increasing productivity and moving up the value chain.

Monday, December 19, 2011

In a recent post, Felix Salmon had a bleak assessment of the Eurozone crisis,

"In every crisis there’s a point of no return — if you don’t do XYZ in time, it’s too late, and the crisis is certain to get out of anybody’s control. I’m increasingly convinced we’ve already passed that point of no return in Europe. The banks won’t lend to each other, the Germans won’t do Eurobonds, and the ECB won’t act as a lender of last resort. The confidence fairy has left the continent, and she isn’t about to return. Which means, as we used to say in 2008, that things are going to get worse before they get worse."

As the increasing bond yields and CDS spreads indicate, the European credit markets are pretty much freezing up. As reflected in the dismal response in recent auction, even the Teutonic credibility of the German bund has taken a dent. Governments are finding that debt refinancing has become very expensive. Banks, with heavy sovereign debt exposures, have become averse to lending anymore, not only to sovereigns but also to each other. Further, they also face rising margin calls due to heightened sovereign debt default risks. The risk of assets turning sour and demand for increased capital requirement (from margin calls), is turning an initial liquidity crisis into a solvency crisis for the banking sector.

In the circumstances, there are two options. The interventionists advocate aggressive measures to restore credit markets (through rate cuts, liquidity injections, credit guarantees, and asset purchases) and bank recapitalization with stringent conditions attached. This is effectively a call to the central bank to step in as a lender, buyer, and insurer of last resort. It would also involve governments taking stakes in banks. Felix Salmon too prefers intervention. His prognosis about the fate of Eurozone is based on this assumption. He believes that the ECB's intransigence and failure to act has driven away the confidence fairy.

The sceptics counter that such measures are likely to be futile. They oppose such bailouts as rewarding reckless and greedy bankers. They also argue that it would merely postpone the hard decisions and belt tightening that are necessary to remove the excesses and distortions created by the skewed pre-crisis growth. Finally, they associate it with trying to restore growth in the aftermath of an asset bubble by inflating another bubble. They point out that the extraordinary monetary easing and liquidity support has the potential to amplify distortions and destablize global financial markets. It would also come in the way of the much needed croeconomic rebalancing among economies of the developed and emerging world.

In this context, as Christina Romer points out, the nature of the response matters critically with any interventionist approach. She points to the contrasting experiences of Sweden in 1991 and Japan in 1992 after their respective banking crises. The former nationalized its banks, recapitalized with public funds, and then returned to private control, with the result that the country returned to its pre-crisis trend within three years. In contrast, Japan refused to clean up its banks, rolling over loans to failing companies, with the result that it continues to grapple with anemic growth and deflation for almost two decades.

It is difficult to make a satisfactory enough judgement call on either position from merely theoretical principles or historical experiences. Both sides could be right and wrong in different ways. In simple terms of a cost-benefit analysis, which option generates higher net benefits? Alternatively, which option would generate the least costs or the less worse set of distortions? Unfortunately, these questions do not have convincing enough answers.

But it is undoubtedly true that bailouts generate moral hazard by taking away the biggest disciplining factor of capitalism. And, as the recent evidence has shown, such bailouts, perversely enough, end up concentrating risk by making the TBTF institutions even bigger.

Update 1 (21/12/2011)

In its role as lender of last resort to banks, the ECB allocated 489.2 billion euros, or $644 billion, to 523 institutions through its longer-term refinancing operations, or LTROs. The loans are for three years and will be at the benchmark 1% interest rate. This is the largest amount ever allocated in a single ECB liquidity operation and first time ECB has extended loans for maturities beyond one year. ECB had started the liquidity operations in the aftermath of the Lehman collapse. It announced that another LTRO will be held in February 2012.

The three-year loans are designed to compensate for a dearth of longer-term market funding, at a time when banks are facing the need to roll over an extraordinarily high amount of their own debt. Banks in the euro zone must raise more than 200 billion euros in the first three months of 2012.

The cheap loans issued by the ECB may also indirectly help governments like Spain and Italy that have faced higher borrowing costs. Spain paid sharply lower interest on debt it auctioned early this week, as banks appeared to use cheap ECB money to buy the bonds, profiting from the difference in interest rates. However, the proceeds could also be used to re-finance existing assets as they become due in the months ahead.

The ECB, as part of its effort to prevent a credit crunch, also broadened the collateral it will accept in return for loans. It is even accepting outstanding loans as security, a measure designed to help smaller community banks that may lack conventional forms of collateral like bonds.

Saturday, December 17, 2011

Eduardo Porter points to the work of IMF economists Andrew Berg and Jonathan Ostry that questions the sustainability of economic growth in conditions of widening inequality. They argue that "sustainable economic reform is possible only when its benefits are widely shared".

They found that in high-inequality nations spurts of growth ended more quickly, and often in painful contractions. They find that a 10 percentile decrease in inequality (represented by a change in the Gini coefficient from 40 to 37) increases the expected length of a growth spell by 50 percent.

They also found that income distribution contributes more to the sustainability of economic growth than does the quality of a country’s political institutions, its foreign debt and openness to trade, the level of foreign investment in the economy and whether its exchange rate is competitive.

The graphic below highlights why widening inequality is a much greater cause for concern in the US

Extreme inequality and its rapid widening is especially bad for developing economies like India, which are even otherwise vulnerable to supply and demand-side business cycle shocks. As Porter briefly mentioned, such widening inequality has implications which go beyond economic stability. It threatens political stability and forces democratic governments down the slippery slope of political populism.

I am inclined to believe that the rapid explosion of competitive populism in India in recent years is in no small measure due to the rapid rise in income inequality and the perceived need for governments to placate increasingly alienated and disgruntled voters who have come to believe that they are being short-changed in the sharing of benefits of liberalization and globalization. As the inequality gap widens further, the propensity for competitive populism will only increase.

This creates a policy gridlock, a low-level equilibrium, from where governments find it difficult, fiscally constrained, to meaningfully address the critical issues that determine sustainable economic growth. Among other things, it contributes to the stifling of reforms and the weakening of governance.